People love to share stock market myths disguised as wisdom about the best investing strategies. Good investors will instead focus on tried-and-true portfolio allocation principles to make sure that they maximize long-term returns. Recognizing the flaws in these three stock market myths can help you manage risks and dodge common pitfalls.
1. Cheap stocks are the same thing as value stocks
Most people have heard that they should “buy low, sell high.” That much might seem obvious, but the actual implementation of this strategy is an entire additional layer of difficulty. A complicated and necessary step is identifying stocks with attractive prices and the potential for growth. This is the keystone of value investing, which involves either buying stocks that trade at a discount to their intrinsic value or finding stocks with attractive valuation ratios relative to peers. That’s a time-consuming challenge at the very minimum, and it could be impossible for investors who are not financial professionals.
Cheap stocks with significant upside do exist, but many such stocks are actually value traps. Value traps appear inexpensive, but they are actually appropriately reflecting the risks facing the company. These companies are generally experiencing slow growth or even contraction, and they often have significant financial obligations in the form of debt.
In extreme cases, they are facing imminent losses from bankruptcy, regulatory fines, or major lawsuits. JC Penney was a famous value trap earlier this decade. There have also been numerous biopharma companies with promising drug candidates that failed to clear clinical trials that have fallen in this category. Cheap stocks with great return potential are out there, but cheaper stocks aren’t always better buys.
2. Indexing is always the best strategy for individuals
Much has been studied about active versus passive investing, and the efficiency of index investing has been demonstrated over the past several decades. A wide array of ETFs and mutual funds have been launched to track a variety of stock indexes as a result. Most active fund managers have failed to outperform the market as a whole over the long term, especially after factoring in the high expense ratios required to run an actively managed fund. Passive indexing allows investors to grow with the market, with minimal trading and management fees incurred to erode returns.
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